Given India’s massive urban infrastructure needs, it will have to rely on different options to raise a share of the resources required.
The urban planner Donald Shoup has evocatively captured one of the great ironies of development, “Why is it so difficult to finance public infrastructure that increases the value of the serviced land by much more than the cost of the infrastructure itself?” The irony is unlikely to strike a chord with a vast majority of us who have been socialised into the belief that property speculation, and the accrual of large increments from various externalities, is the most remunerative investment category. The high economic growth rates and rapid urbanisation of the last two decades has been accompanied by massive public and private investments, especially in the suburban fringes of all our cities, fuelling property booms.
Governments have made large investments in transportation infrastructure assets like roads, airports, and mass transit that have opened up vast suburban hinterlands. Similarly, private investments in townships, industries, and commercial establishments have catalysed rapid economic development in those areas. These investments typically generate large positive externalities, most of which get captured by surrounding property owners in the form of higher land prices. In both cases, investors create value, a major share of which is captured by others. This “unearned increment” is amplified by the distortions in our property registration system.
Such passive value accretion makes real estate one of the hottest investment assets. A large share of such land transactions are purely speculative in nature, done in anticipation of a new investments in the neighbourhood and the objective of capturing the increase in valuations and then exiting. This creates large resource mis-allocation problems, crowding scarce investment resources out of productive sectors and into speculative activities. It is no surprise that real estate contributes a disproportionately large share of India’s new generation billionaires.
Its unfairness and inefficiency apart, this turn of events creates another sub-optimal outcome. Since governments recover limited value from its investments, their capacity to make similar investments elsewhere is constrained. Private developers will be loath to make large investments when a major share of its returns is captured by others. Economists tell us that this is true of all positive externalities. When faced with such situations, there will be an under-supply of the activities that create the positive externalities. Governments and developers under- invest in such developments, leaving every one worse off.
This problem assumes even greater significance given the vast potential for such investments in India and the even greater demand for them, both of which are unfortunately constrained by scarce resources. Many governments across the world have sought to address this problem by attempting to capture some share of the value increment using various innovative policies. For fiscally strained local and state governments in India, this may be their greatest opportunity to finance their massive investment needs.
The commonest strategy to capture value created by investment externalities is through different forms of taxation. They include betterment charges, impact fees, or higher building fees. A widely used approach, tax-increment financing (TIF), imposes a tax increment on properties in the surrounding areas for some years. In all these cases, the tax is packaged as a levy to finance the new infrastructure investment in the area.
The most ideal value capture tool – used by countries like Denmark, Australia, and New Zealand – is an annual land-value tax on the increment of (built-up) land value. Apart from capturing any value increment, it would also stabilise property prices and discourage speculative investments. However, the absence of transparent price discovery in Indian property markets and poor state of land titles make its administration difficult.
The most direct value capture is for governments to build land banks through strategic acquisitions. Once a part is developed, the value of the remaining land rises and the government can capture the entire increment by selling it. However, given the political economy surrounding land transactions, this government-as-realtor strategy is likely to breed undesirable practices.
A more effective approach to capture value is through innovative applications of functional and density zoning regulations. Changes in land usage (say, from agricultural to commercial) and relaxation of height restrictions can dramatically increase property prices. It is only appropriate that a share of the value increment from such changes be captured by the government. A common value capture instrument is to mandate that a certain share of the land being developed be earmarked for affordable housing. Local governments in some European countries mandate a share of the developed land to be transferred to it.
In this context, given the prevailing low permissible Floor Area Ratio (FAR), Indian cities can emulate the the French land-use policy which restricts the landowner’s property right to a low baseline FAR and building rights beyond that as a public resource. Additional construction, upto the limit laid out in the Master Plan for that area, can be purchased for a building right fee or by meeting an affordable housing mandate. Some Indian cities, led by Hyderabad, have allowed additional FAR to acquire land for widening roads.
Many Brazilian cities have used the sale of building rights to not only raise resources but also guide densified urban growth along transit corridors. In 1995, the Brazilian city of Sao Paulo introduced an innovative instrument, Certificates of Additional Potential Construction Bonds (CEPACs), to facilitate price discovery for the additional building rights. It sold a limited quantity of building rights for a large enough area – one CEPAC for each square meter of additional building right – through an electronic auction. The national securities market regulator regulates the issuance of CEPACs. Those proposing to build over the basic FAR would have to purchase CEPACs from the secondary market. The city holds periodic auctions for each area, gradually releasing additional FAR so as to maximize the value capture. This can be a potentially useful strategy for transparent value capture, especially in new developments.
Apart from these, in India, a few states like Haryana and Gujarat have successfully used land assembly programs where the owners agree to exchange their barren lands for infrastructure-serviced smaller plots. A portion of the developed land is used to finance the cost of providing infrastructure. Given India’s massive urban infrastructure needs, it will have to rely on these options to raise a share of the resources required.